‘Til Death Do U$ Part

Last May, after several months of controversy and fierce
debate, the Congress passed a series of changes to the U.S.
estate tax as part of the federal budget. Given the political
realities (in particular, the promise to keep total ten-year
tax cuts under $1.35 trillion) and the intensity of feelings
surrounding this issue, perhaps no one should be surprised
that the resulting legislation was a major compromise. § The
bill reduced the top estate tax rate, from 55 to 50 percent
in 2002, and then to 45 percent in 2007. It increased the
amount of assets that are exempt from tax, from $1 million
in 2002 to $3.5 million in 2009. States will help compensate
for the federal revenue loss by giving up their share of estate
tax revenue as of 2005, even though federal revenue will continue
to be collected until 2010. § In 2010, the estate tax is to
be repealed entirely; instead, a capital gains tax will be
levied on many types of inherited assets that now can be bequeathed
at current market value (and effectively escape being taxed).
Then, in 2011, all tax cuts in the budget bill (not just the
estate tax provisions) will expire, a move necessary to keep
the total cost of the bill under the agreed upon amount. §
The legislation included something to make everyone unhappy.
For those who want to abolish the estate tax permanently (“no
taxation without respiration”), that the death of the “death
tax” doesn’t occur for almost a decade is cause for concern—and
its reinstatement one year later provides little added comfort.
For those who feel strongly about using the estate tax as
a way to redistribute wealth from richer to poorer, the changes,
which disproportionately benefit the very richest Americans,
were disheartening. Whatever their perspective, most agree
that the bill’s provisions, especially the repeal followed
by reinstatement a year later, virtually guarantee that both
the country and the Congress will revisit the issue in the
not-so-distant future.

How did we get here?

The first U.S. tax on the transfer of assets at death occurred
in 1797, when faced with the expense of resisting French attacks
on American ships, the Congress imposed a duty on receipts
for legacies and probates for wills; the tax was repealed
in 1802. Similar taxes were imposed in 1862 (to pay for the
Civil War), 1894, and in 1898 (to pay for the Spanish-American
War). These were also later repealed or declared unconstitutional.

It was only after 1916 that the modern estate tax became
a permanent feature of the U.S. economy. Originally instituted
to help pay for World War I, the tax was part of Progressive
Era legislation that aimed to replace the federal custom and
excise taxes, the main source of tax revenues, with, first,
a federal income tax (1913), followed by the estate tax (1916).
For those in favor of this change, estate and income taxes
were preferable to excise taxes because the structure of tax
rates made their impact “progressive”—that is, households
with more wealth (income) paid a larger share of that wealth
(income) in taxes. Yet, just as now, this was not everyone’s
view. Opponents of the new estate tax called it a “fiscal
crime” and a “project of confiscation.”

In the original 1916 law, the first $50,000 was exempt from
tax, and rates ranged from 1 percent (on the first $50,000
transferred) to 10 percent (on assets over $5 million transferred).
Many changes followed; tax rates reached as high as 77 percent
(in 1977) and exemptions also were increased. By the time
the 2001 budget bill passed, an estate had to be greater than
$675,000 before owing any taxes. An estate of unlimited value
could be left to a spouse without incurring tax (although
when the spouse died, taxes would be owed on what was left).
And, although many did not take full advantage of the rule,
$10,000 per year could be given to each child and grandchild,
which reduced the size of many otherwise taxable estates below
the level where tax would be owed. Thus, only about 2 percent
of estates paid any estate taxes.

The economic impact

The economic impact of changes in the estate tax is difficult
to assess. First, one must be careful to separate timing changes,
for example, the decision of when to give a gift or sell an
asset, from “real” changes or actual changes in magnitudes.
Second, impacts will depend on the specific provisions of
the law that are changed. And third, the relationship of the
tax system to the economy is enormously intricate, so untangling
the effect of even a relatively simple tax change, especially
over time, is extremely difficult. Having said that, it is
useful to consider some of the more significant potential
impacts.

TAX REVENUE. Estate tax revenues totaled about $25 billion
in 1999, accounting for less than 1.5 percent of federal revenues.
Many observers on both sides of the issue do not view this
as a particularly large number. In making the case against
the estate tax, members of the House Joint Economic Committee,
observed, “The individual income tax raised more revenue in
1998 alone than the estate tax has during the entire 20th
century.” William Gale of Brookings and Joel Slemrod of the
University of Michigan, who generally favor an estate tax,
find it “remarkable” that a tax that generates so little revenue
can be the subject of such heated dispute.

Despite the relatively small collections, many proponents
believe the estate tax is necessary to protect the “integrity”
of the income tax. In this view, the estate tax functions
as a backstop for income that would otherwise escape taxation.
Under current rules, for example, heirs receive stock, antiques,
and other real property at current market value (at a “stepped-up
basis”) rather than at historical cost. Thus, no one pays
income tax on any capital gains that accrued during the giver’s
lifetime. Opponents suggest that this will be addressed by
combining the elimination of the estate tax with an expanded
capital gains tax, as the budget bill does. Proponents reply
that an expanded capital gains tax imposes substantial paperwork
and administrative requirements (such as keeping records,
having to figure the value of assets that are difficult to
value absent a sale) and may not ultimately prove viable.

Proponents also worry that permanent elimination of the
estate tax will compromise the progressive nature of the income
tax, by encouraging certain wealthy people to convert income
into assets and thereby reduce their overall tax. They could,
for example, load their portfolio with non-income-bearing
assets that accrue returns in the form of capital gains rather
than dividends on which they would pay income tax.

As it stands, the estate tax changes will have substantial
revenue consequences for the states. Most states tie their
estate tax to the federal estate tax, with taxpayers receiving
a dollar-for-dollar credit against their federal liability.
As of January 2001, 35 states had their estate tax structured
to exactly equal this “pickup tax.” In effect, this sends
a portion of federal estate tax revenues to the states without
increasing the total tax paid. States are free to impose additional
taxes. Connecticut and New Hampshire currently also have an
inheritance tax (so-called because it is levied on the heirs,
not on the estate), although Connecticut is phasing its inheritance
tax out.

The elimination of the state credit, due to take effect
in 2005, will reduce state tax coffers unless other sources
of funds are found. Some states are more reliant on the federal
credit than others. Florida gets more than 2.5 percent of
revenues from its credit. New Hampshire, with no income or
sales tax (at least for now), would be the hardest hit state
on a percentage basis. It stands to lose about $25 million,
or 4.6 percent of revenue. Vermont, Rhode Island, and Connecticut
receive more than 2 percent of state revenue this way.

Even without the new law, federal revenue collections—and
the share of estates that are large enough to owe estate tax—could
grow over the next decade. Rising prices in the stock and
housing markets increased the wealth of many Americans during
the 1990s and put them within sight of owing tax. In addition,
the 1976 legislation that established the unlimited deduction
for spouses probably slowed revenue growth over the past 25
years. Now, as the second spouse of the couple dies and estate
taxes come due, the share of estates that are taxable—and
tax collections—may increase.

Perhaps that is why a recent survey found that 17 percent
of Americans expect to owe estate tax, even though fewer than
2 percent currently do so. People may be concerned because
they have watched the rising values of their home and stock
portfolio. Or they may be overly optimistic about the likelihood
of becoming wealthy. Perhaps they worry about the estate tax
rather than face the low probability that they will ever become
rich.

WORK, SAVING, AND INVESTMENT. Another concern is that the
estate tax reduces the incentive to entrepreneurial energy,
saving, and investment—and that this could hamper capital
accumulation and economic growth. As an argument, this can
cut both ways. On the one hand, net saving is quite concentrated
among the wealthy. According to one study, the top 1 percent
of wealth-holders in 1986 accounted for about half of all
savings between 1983 and 1986; reducing the estate tax might
further increase their incentive to save. On the other hand,
if people “target” the size of their bequests, then eliminating
the estate tax could decrease saving as people reach their
target more quickly. And the very richest people, who pay
the bulk of estate tax, seem to engage in saving and accumulating
wealth for reasons that go beyond bequests. To the extent
that they build wealth for other reasons—to attain status
and power, for example—reducing the estate tax may have little
or no impact.

The effect of the estate tax on capital accumulation, savings,
and economic growth is surprisingly little studied, say William
Gale of Brookings and Maria G. Perozek of the Federal Reserve
Board of Governors. In part, this is because we need to understand
the motives for bequests, especially the motives of the very
rich about whom relatively little is known. Some people may
leave an estate “accidentally” because they are not sure when
they will die and cannot time their consumption to spend their
last cent exactly as they take their last breath. Or, in the
case of the super rich, simply because they cannot spend their
billions. Reducing the estate tax would not have much impact
on such unintended bequests.

But bequests may also be intentional, arising out of the
desire to leave money to children or others. This is where
a change in the estate tax might have its biggest impact on
wealth accumulation and growth. By reducing the ability of
a person to transfer income, the tax may discourage work effort
and encourage consumption. Several studies find that reducing
estate taxes would likely increase the economy’s ratio of
capital to labor, although they do not agree on whether the
effect would be small or large. Another study finds that inheritance
may increase savings by parents but may reduce savings
by heirs. Still another finds that the probability of starting
a successful business increases with a large inheritance,
suggesting that eliminating the estate tax may reduce business
investment.

Finally, some parents may use bequests to encourage their
children to attend college, care for them in old age, or act
in otherwise desirable (to the parents) ways. They may even
hope to influence actions from the grave. Senator Joseph Lieberman,
as executor of his uncle’s $48 million estate, had to decide
how to enforce his uncle’s wish that his cousins be disinherited
if they did not marry within the Jewish faith. The impact
of the estate tax, in these instances, depends on the cost
of eliciting a child’s desired actions. If, for example, parents
are willing to pay a high price (and their children require
it), increased estate taxes will tend to raise the parent’s
target bequest, and thus raise their incentive to save and
accumulate wealth.

In the real world, motives for bequests are not easy to
disentangle. And the evidence is mixed, and tricky to interpret.
Research—and common sense—suggest that all motives probably
coexist in the economy, even within a single individual. This
makes it difficult to determine how much entrepreneurial energy,
saving, and investment will be affected by a tax change. It
also implies we should be careful about leaning too hard on
such estimates when setting policy.

CHARITABLE GIVING. The proposed elimination of the estate
tax has raised concern about its potential impact on the tax-exempt
charities and nonprofits—museums, cultural groups, service
organizations, educational and religious institutions, and
hospitals—that depend on donations. Most studies find that
the deductibility of charitable gifts generated a significant
increase in contributions at death, and may even have increased
gifts during the donor’s life, in anticipation of future taxes.
Opponents question the size and significance of the impact.

EVASION, AVOIDANCE, COMPLIANCE, AND ADMINISTRATIVE COSTS.
Where there are taxes, there is the incentive to avoid them.
And the estate tax is so easy to avoid, say some critics,
that it is essentially “voluntary.” One New York City attorney
estimated in The Wall Street Journal that he could
lose 75 percent of his practice if the estate tax were abolished.
Opponents of the estate tax argue that resources put into
rearranging assets to minimize taxes could be better spent
on education, healthcare, or other consumption or investment.
The costs to the taxpayer in paperwork and effort, and to
the government in monitoring and enforcement could also be
put to more productive use.

But measuring the extent of these costs is difficult. Estimates
of compliance and administrative costs range widely, from
10 percent to 100 percent of the tax collected. Estimates
of the costs of (legal) tax avoidance are sketchy and depend
on relatively arbitrary assumptions. As for (illegal) tax
evasion, consultant Brian Erard studied how estate taxes increased
or decreased after an audit and estimated evasion to be about
13 percent of the potential tax base—a figure slightly lower
than for the income tax.

FAIRNESS. Much of the heat over the estate tax is generated,
not by its narrow economic impact, but by concerns about fairness.
Many proponents believe that tax and spending policy should
be used to help even up—not exacerbate—differences in opportunity.
In this vein, George Soros, Warren Buffett, and Bill Gates,
Sr., have likened eliminating the estate tax to choosing the
U.S. Olympic team according to whether one’s parents had been
Olympians. The decline in prospects for the less educated
during the last quarter century has only underlined this concern.

Whether measured by the wealth of the person making the
bequest or by the person receiving the inheritance, the estate
tax is “progressive,” even more so than the income tax. Household
wealth in the United States is very concentrated, far more
concentrated than income, notes NYU Professor Edward Wolff,
with the top 1 percent of households holding 36 percent of
net worth. The U.S. Treasury estimates that households in
the top 1 percent of the income distribution pay 25 percent
of income taxes, but almost two-thirds of all estate taxes.

Even as measured by the income of heirs, the estate tax
is highly progressive. In 1981, the average adjusted gross
income was $47,400 for all households that received inheritances
subject to estate tax. It was $123,000 for recipients of estates
between $2.5 and $10 million, as compared to U.S. median family
income of $23,800. Moreover, many proponents think that while
it is possible to raise this revenue in an equally progressive
manner with the income tax, it may be less efficient.

On the other hand, wealthy parents may transfer the most
important assets to children before they die. Paying for college
or professional school, providing access to contacts, or lending
seed money for a new business, all are ways to give children
a leg up that poor parents cannot match. The estate tax may
hold only a limited ability to even the score.

Those who oppose the tax on grounds of fairness may take
as fundamental the right of an individual to dispose of the
fruits of his or her labor, and particularly the right to
to leave them to one’s children. Others believe that it is
an act of bad faith to impose a tax at a time when people
are grieving. The prospect of filing forms and facing an audit
can seem terribly unfair (although only estates equal to or
greater than the exempt amount must file). Having to set a
value on and divide property can exacerbate family tensions
at a vulnerable time, although any will that distributes assets
in percentage terms requires this, even in the absence of
an estate tax.

Opponents also argue that the estate tax unfairly punishes
frugal savers while encouraging wanton spenders. Leave children
$2 million for their kids college education, and it will be
subject to estate tax; throw a $2 million party in Morocco
for 800 of your closest friends—as Malcolm Forbes did for
his 70th birthday party— and the government doesn’t take an
extra penny. Last year in an editorial, The Wall Street
Journal called the estate tax “a tax on virtue.”

The impact on small businesses and family farms has also
been a focus of considerable attention. In fact, small businesses
received favorable treatment even prior to the new law. They
could value assets at “use” rather than “market” value, and
reduce the taxable worth of the estate by up to $770,000 (indexed
for inflation). They could put assets, even publicly-traded
assets, in limited family partnerships to further decrease
the size of the estate. And they could stretch out tax payments
for up to 14 years. One study found that almost 60 percent
of small firms held liquid assets equal to the estate taxes
owed. Alternatively, a firm’s owner can buy a life insurance
policy with the proceeds to cover the expected tax so that
heirs will not have to sell the business to cover it.

Nevertheless, compliance and tax planning can cause huge
headaches. Despite the availability of insurance, and for
reasons that are not clear, firms tend to be underinsured.
And some end up in costly disputes with the IRS. Frederick’s
of Hollywood just ended such a six-year battle. At issue:
how to value a large block of stock that was in the owner’s
estate—at a premium because the block conferred control of
the company or at discount because selling the shares at one
time would depress the price. By the time the family prevailed,
Frederick’s was already in bankruptcy proceedings. “We lost
the war before we won the battle,” said the estate’s co-executor
to The Wall Street Journal. Yet, family members agree
that some of the company’s woes were due to internal disputes
over its future direction. Succession in a small business
involves difficult and emotional decisions even in the absence
of an estate tax. In the heat of the moment, the tax may feel
like the culprit.

Death and taxes

Everyone in America wants to believe that he or she will
eventually be rich. And so the estate tax is a tough story
to sell. In a 1990 Gallup Poll, respondents said that they
thought 21 percent of their fellow citizens were rich. When
asked how much annual income that would take, their median
response was $95,000—the income level of the top 4 percent
of households.

Those who do make it into the upper brackets tend to underestimate
their own wealth. Only 7 percent of respondents considered
themselves “upper-income” and less than one-half of 1 percent
admitted to being “rich.” What looks rich from afar, may not
feel so rich once you arrive.

And while everyone wants to be rich, almost no one likes
thinking about or planning for death. Maybe if we eliminate
the estate tax, we won’t have to face our own mortality. It
is only human nature to want to put off confronting the inevitable.

For further reading

“A Quarter Century of Estate Tax Reforms,” by David Joulfaian,
Office of Tax Analysis, U.S. Department of the Treasury, National
Tax Journal, Vol. 53, No. 3, pp. 343-360.